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Guide to Understanding the Debt to Equity Ratio (D/E)

Last Updated December 6, 2023

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## What is Debt to Equity Ratio?

The **Debt to Equity Ratio (D/E)** measures a company’s financial risk by comparing its total outstanding debt obligations to the value of its shareholders’ equity account.

## How to Calculate Debt to Equity Ratio (D/E)?

The debt-to-equity ratio (D/E) compares the total debt balance on a company’s balance sheet to the value of its total shareholders’ equity.

The D/E ratio represents the proportion of financing that came from creditors (debt) versus shareholders (equity).

- Debt → The debt component comprises any short-term borrowings, long-term debt, and any debt-like items on the company’s balance sheet
- Shareholders’ Equity → The equity component is inclusive of any equity contributed by the owners (i.e. founders), equity raised in the capital markets, and retained earnings.

In general, if a company’s D/E ratio is too high, that signals that the company is at risk of financial distress (i.e. at risk of being unable to meet required debt obligations).

However, a low D/E ratio is not necessarily a positive sign, as the company could be relying too much on equity financing, which is costlier than debt.

In addition, the reluctance to raise debt can cause the company to miss out on growth opportunities to fund expansion plans, as well as not benefit from the “tax shield” from interest expense.

## Debt to Equity Ratio Formula (D/E)

The formula for calculating the debt-to-equity ratio (D/E) is as follows.

**Debt to Equity Ratio (D/E) = **Total Debt** ÷**Total Shareholders Equity

For example, let’s say a company carries $200 million in total debt and $100 million in shareholders’ equity per its balance sheet.

- Total Debt = $200 million
- Shareholders’ Equity = $100 million

Upon plugging those figures into our formula, the implied D/E ratio is 2.0x.

- D/E Ratio = $200 million / $100 million = 2.0x

Conceptually, the D/E ratio answers, *“For each dollar of equity contributed, how much in debt financing is there?”*

So, the debt-to-equity ratio of 2.0x indicates that our hypothetical company is financed with $2.00 of debt for each $1.00 of equity.

That said if the D/E ratio is 1.0x, creditors and shareholders have an equal stake in the company’s assets, while a higher D/E ratio implies there is greater credit risk due to the higher relative reliance on debt.

## What is a Good Debt to Equity Ratio?

Lenders and debt investors prefer lower D/E ratios as that implies there is less reliance on debt financing to fund operations – i.e. working capital requirements such as the purchase of inventory.

By contrast, higher D/E ratios imply the company’s operations depend more on debt capital – which means creditors have greater claims on the assets of the company in a liquidation scenario.

For lenders, the existing debt on the balance sheet causes the borrower to be riskier to work with, especially for risk-averse debt lenders – and for shareholders, more debt means there are more claims on the company’s assets with higher priority than that of the shareholders.

Lenders and investors perceive borrowers funded primarily with equity (e.g. owners’ equity, outside equity raised, retained earnings) more favorably.

Under a hypothetical liquidation, including for creditors placed lower in the capital structure behind senior lenders, full recovery is not guaranteed – therefore, pre-existing creditors holding substantial claims on the company’s assets (and liens) increase the risk to creditors of lower seniority and equity holders.

## How to Interpret the D/E Ratio?

While not a regular occurrence, it is possible for a company to have a negative D/E ratio, which means the company’s shareholders’ equity balance has turned negative.

- Negative D/E Ratio → A negative D/E ratio means the company in question has more debt than assets.
- Positive D/E Ratio → A positive D/E ratio, on the other hand, implies the company has more assets than debt.

In the majority of cases, a negative D/E ratio is considered a risky sign, and the company might be at risk of bankruptcy. However, it could also mean the company issued shareholders significant dividends.

## Debt to Equity Ratio Calculator (D/E)

We’ll now move to a modeling exercise, which you can access by filling out the form below.

## 1. Balance Sheet Assumptions

In our debt-to-equity ratio (D/E) modeling exercise, we’ll forecast a hypothetical company’s balance sheet for five years.

As of Year 1, the following assumptions will be used and extended across the entire projection period (i.e. held constant).

- Cash and Cash Equivalents = $60m
- Accounts Receivable = $50m
- Inventory = $85m
- Property, Plant & Equipment (PP&E) = $100m
- Short-Term Debt = $40m
- Long-Term Debt = $80m

From the above, we can calculate our company’s current assets as $195m and total assets as $295m in the first year of the forecast – and on the other side, $120m in total debt in the same period.

For purposes of simplicity, the liabilities on our balance sheet are only short-term and long-term debt.

Thus, the total equity in Year 1 is $175m for the balance sheet to remain in balance.

For the remainder of the forecast, the short-term debt will grow by $2m each year, while the long-term debt will grow by $5m.

## 2. Debt to Equity Ratio Calculation Example (D/E)

The debt-to-equity ratio (D/E) is calculated by dividing the total debt balance by the total equity balance, as shown below.

In Year 1, for instance, the D/E ratio comes out to 0.7x.

- Debt to Equity Ratio (D/E) = $120m ÷ $175m = 0.7x

## 3. D/E Ratio Calculation Analysis Example

From Year 1 to Year 5, the D/E ratio increases each year until reaching 1.0x in the final projection period.

- D/E Ratio – Year 1 = 0.7x
- D/E Ratio – Year 2 = 0.8x
- D/E Ratio – Year 3 = 0.8x
- D/E Ratio – Year 4 = 0.9x
- D/E Ratio – Year 5 = 1.0x

Since the debt amount and equity amount are practically the same – $148m vs. $147m – the takeaway is the debt-to-equity ratio (D/E) in Year 5 implies that the value attributable to creditors and shareholders is equivalent according to the balance sheet.

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Miriam

June 3, 2023 12:06 pm

Excellent explanation

Reply

I am an expert and enthusiast based assistant. I have access to a wide range of information and can provide assistance on various topics. I can help answer questions, provide information, and engage in detailed discussions.

Regarding the article you mentioned, "Accounting Guide to Understanding the Debt to Equity Ratio (D/E)," I can provide information related to the concepts used in the article. Let's dive into it!

#### What is Debt to Equity Ratio?

The Debt to Equity Ratio (D/E) is a financial metric that measures a company's financial risk by comparing its total outstanding debt obligations to the value of its shareholders' equity account. It helps assess the proportion of financing that came from creditors (debt) versus shareholders (equity).

#### How to Calculate Debt to Equity Ratio (D/E)?

The debt-to-equity ratio (D/E) is calculated by comparing the total debt balance on a company's balance sheet to the value of its total shareholders' equity. The formula for calculating the D/E ratio is as follows:

**Debt to Equity Ratio (D/E) = Total Debt ÷ Total Shareholders Equity**
The debt component includes short-term borrowings, long-term debt, and any debt-like items on the company's balance sheet. The equity component includes equity contributed by the owners, equity raised in the capital markets, and retained earnings.

#### What is a Good Debt to Equity Ratio?

Lenders and debt investors generally prefer lower D/E ratios, as it implies less reliance on debt financing to fund operations. Higher D/E ratios indicate that a company's operations depend more on debt capital, which means creditors have greater claims on the company's assets in a liquidation scenario.

However, it's important to note that a low D/E ratio is not necessarily a positive sign. A company relying too much on equity financing may miss out on growth opportunities and not benefit from the "tax shield" provided by interest expense. It's a balancing act between debt and equity financing.

#### How to Interpret the D/E Ratio?

The D/E ratio provides insights into the company's capital structure and financial risk. A D/E ratio of 1.0x indicates that creditors and shareholders have an equal stake in the company's assets. A higher D/E ratio implies greater credit risk due to a higher relative reliance on debt.

It's worth mentioning that a negative D/E ratio means the company has more debt than assets, which is generally considered a risky sign. On the other hand, a positive D/E ratio implies the company has more assets than debt.

These are the key concepts related to the Debt to Equity Ratio (D/E) discussed in the article. If you have any further questions or need more information, feel free to ask!